Sunday, May 1, 2011

The Aggressive Conservative Investor: Chapter 8

Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.

The assumptions underlying GAAP are discussed in this chapter. The authors believe readers should grasp some of GAAP's hidden assumptions in order to become better users of financial statements.

Three major myths of GAAP are discussed. The first is that statements are rigid and codified. But this is not the case, as preparers of statements have great flexibility compared to say preparers of statements for tax purposes. The second myth is that GAAP is all encompassing and can be used to measure all forms of corporate phenomena. The third myth is that GAAP can be made to tell a certain "truth". The authors point out there that there is not a single type of user (even among investors) and therefore all GAAP assumptions require trade-offs that may help one group of users at the expense of others.

It is also important for investors to recognize that GAAP is based on tangible property, but that many sources of income come from intangibles, including:

- a company's ability to finance itself (through either debt or equity)
- favourable or unfavourable contracts with customers/employees/suppliers etc.
- trade names and patents
- distribution channels
- know-how

Furthermore, as the United States economy continually shifts to a more service-based economy, GAAP becomes less useful at measuring value. For example, it is straightforward for GAAP to count a newly purchased piece of manufacturing equipment, but GAAP fails at measuring the value of a group of employees with advanced medical degrees.

GAAP also doesn't recognize the fact that few assets of a going concern have values that are independent of that going concern. A new asset can be worth much more than its purchase price (or in some cases, can even have a negative value!) when combined with the assets of the rest of the business. GAAP does not capture the relationship between assets.

Finally, GAAP appears to be aimed at the buyer of securities rather than the seller. Because of the "conservatism" principle, GAAP is telling "how bad things can be", and is thus more useful for a buyer of a security. On the other hand, a seller might like to know "how good things can get", but GAAP offers no such symmetry.

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